United States: Inside M&A - May/June 2009

Last Updated: July 2 2009

Advantages of Using ESOPs to Structure Acquisitions and Divestitures in an Uncertain Economy

New York Cases Involving S Corporations

Pre-Packaged Sales in Administration in the United Kingdom

New Belgian Law on Business Reorganization Takes Effect

Distressing Times Pose Special Risks for PE (Mergers & Acquisitions)

Intelligent Risk-Taking (The Deal)

Advantages of Using ESOPs to Structure Acquisitions and Divestitures in an Uncertain Economy
By William W. Merten

For years, employee stock ownership plans (ESOPs) have provided both a ready exit strategy for privately held business owners and a platform for management buyouts. More recently, M&A advisors have used leveraged ESOPs to accomplish both conventional stock and asset acquisitions and divestitures (including spin-offs of divisions or companies (e.g., failed "roll-up" companies). They have also been used by venture capital and private equity firms (collectively, private equity groups) as investment platforms and in planning investment exit strategies.

In the current economic environment, leveraged ESOPs can continue to be used for all of these purposes. They can also provide real advantages not available in traditional M&A transactions. With company owners postponing sales in the face of lower values and inferior offers, ESOPs allow for partial sales, maximize after-tax sales proceeds and provide sources of financing that are both tax-advantaged and flexible. The leveraged ESOP structure also provides an increase to company cash flow, and, on a go-forward basis, a more stable company structure with improved performance. Seller financing may also be measurably more attractive in an ESOP purchase scenario than under traditional M&A models.

Advantages Available in ESOP Structure

ESOP as Qualified Retirement Plan That Can Borrow Funds to Create Market and Make "Internal" Purchase of Shares

An ESOP is no more than a defined contribution plan like a profit sharing or 401(k) plan. It is designed to invest most of its assets in the stock of the sponsoring corporation (Company).

Unlike other qualified plans, an ESOP can use both borrowed money and funds rolled over tax-free from other qualified retirement plans and/or certain individual retirement accounts (IRAs) to purchase the stock of the sponsoring corporation. Armed with this ability, in uncertain economic times ESOPs can create a market for closely held shares that might not otherwise exist. Shares can be purchased from one or more individuals or entities looking for shareholder liquidity (Sellers) or from the Company itself.

Because an ESOP purchase can be structured internally (i.e., without "taking the Company to market"), the transaction can be more easily closed within a specific time frame that meets buyer and/or seller objectives. If desired, an ESOP purchase offer can alternatively be timed to occur concurrently with additional M&A offers (with the ESOP serving as a "stalking horse" to potentially increase third-party M&A offers).

Possibility of Partial and/or Tax-Deferred Sale Makes ESOP Purchase Transaction Attractive to Seller

Partial Purchase Capability

An ESOP can purchase part or all of a company's shares, and it need not purchase the shares in a single transaction. For a business owner seeking partial liquidity, an ESOP may be extremely attractive compared to traditional M&A transactions in which buyers are rarely willing to purchase a minority interest.

Possible Tax-Deferred or Tax-Free Sale

Moreover, as long as the ESOP purchases at least 30 percent of the Company's shares, and the Company was privately held (or an OTCBB company) for at least one year prior to the ESOP's stock purchase, was not a member of a corporate controlled group that included a public company (other than an OTCBB company) during such period, and was a C corporation at the time of the ESOP's stock purchase, then a selling shareholder that (i) is an individual, trust, partnership or S corporation and (ii) has held its shares for at least three years prior to the sale closing date is able to make a tax-deferral election with respect to the sale under Section 1042 of the Internal Revenue Code.

Such an election will allow the Seller to sell his/her/its shares on a tax-deferred (or, in the case of individual Sellers) tax-free basis. Tax-deferred sale treatment is generally available if the Seller reinvests the Seller's sale proceeds in domestic stocks and bonds (replacement securities) within 12 months of the transaction closing date. Tax-free sale treatment is generally available to the extent that an individual Seller acquires replacement securities in an amount equal to the ESOP purchase price and then holds them until his or her death. The Internal Revenue Service (IRS) makes it quite easy to hold replacement securities until death, since neither (i) gifting or making charitable contributions of the securities, nor (ii) borrowing against them (e.g., through margin loans) constitutes a disposition of the securities for purposes of the applicable IRS rules.

Even If Sale Is Not Tax-Deferred or Tax-Free, It Will Result in Capital Gains

In the event that an ESOP purchases a Seller's shares and the Seller chooses not to make (or fails to qualify for the making of ) a tax-deferred election under Section 1042, the sale will result in capital gains (currently subject to a 15 percent federal income tax rate). Given that (i) many buyers in a traditional M&A transaction want to purchase assets, (ii) private equity and strategic buyers will generally pay a lower purchase price for stock than for assets, and (iii) an asset sale typically results in a blended capital gains/ordinary income tax rate and sometimes a double tax if the corporation then liquidates, a Seller's ability to make a tax-deferred or capital gain stock sale to an ESOP is a real advantage. In a challenging economic environment, it may be the principal factor or, perhaps, the only factor that encourages an owner to sell now rather than later. Putting more after-tax dollars into a Seller's pocket can also bring about a "meeting of the minds" in terms of the transaction purchase price. It can further provide a competitive advantage to a purchaser that is offering the same price as competing buyers.

One of the great "ESOP fables" is that an ESOP won't pay as high a purchase price as an outside third party might. While it is true that an ESOP can't pay a true "strategic" purchase price, it can pay a price equaling a Company's full economic fair market value. As credit markets have contracted, so too have the pricing multiples paid by strategic buyers, with ESOP offers in the current economic climate sometimes even exceeding strategic offers when viewed on an after-tax basis.

ESOP Financing That Is Tax-Advantaged and More Flexible

Structure of ESOP Loan (with Possible Reduction of Transaction Debt)

A corporation (Company) wishing to engage in a leveraged ESOP stock purchase transaction adopts an ESOP, and the ESOP typically borrows its share purchase money from the Company and/or the Seller(s) (with the Company portion of the funds so borrowed by the ESOP sometimes having been sourced by the Company from one or more senior lenders). The amount borrowed is reduced to the extent employees are given, and take advantage of, an opportunity to transfer some or all of their 401(k), profit sharing and/or IRA account balances to the ESOP for investment in Company shares (with dollars coming into the ESOP (i) reducing the amount of both ESOP debt and Company debt, and (ii) being viewed as transaction equity by senior lenders).

Repayment of Both Interest and Principal with Deductible Dollars

The ESOP loan (whether from a bank, the Company which borrowed the funds from a bank and/or the Seller) is repaid with contributions made by the Company to the ESOP plan and/or C corporation dividends or S corporation distributions paid on the ESOP's Company shares (ESOP shares). In the aggregate, the contributions and dividend/distributions generally equal the transaction's debt service. Because an ESOP is a qualified plan, an ESOP sponsor receives a deduction for the contribution the sponsor makes to the ESOP. If a sponsor is a C corporation, it will also be able to deduct reasonable dividends paid on ESOP shares that are used to retire the ESOP loan.

Contributions and/or distributions received by the ESOP are used by it to repay its debt service to the Company, with the Company then using the monies it receives to repay its debt service to the bank or the Seller. Since the aggregate amount of deductible contributions and dividends is generally enough to service, first, the ESOP's indebtedness to the Company and, second, the Company's indebtedness to the bank, the Company is effectively able to deduct both the interest and the principal on its bank loan.

Resulting Increased Cash Flow (Which May Last Beyond Loan Term with S Corporation Election)

Because the Company is essentially able to repay its indebtedness on a pre-tax basis, the Company's cash flow is increased. Moreover, if the Company is an S corporation or a C corporation as to which a post-transaction S corporation election will be made, the enhancement to the Company's cash flow need not be limited to the term of the transaction-related deductions. The reason is that an S corporation is a pass-through entity and an ESOP is a tax-exempt entity. If the Company remains or becomes an S corporation, there will be no federal income tax (and, perhaps, no state income taxes) to the extent of the ESOP's Company ownership percentage. If the ESOP winds up owning 100 percent of the Company's outstanding shares (albeit that options, warrants or other forms of synthetic equity may, for example, be held by the Company's management team and/or private equity investors), the Company can operate on a go-forward basis as an entity exempt from federal (and, in many cases, state) income taxes.

Benefits of Increased Cash Flow

The increased cash flow of the Company related to ESOP-generated deductions in a C corporation context or the ESOP's ownership percentage in an S corporation context can be used to make scheduled or accelerated transaction-related debt service payments. It can also be used for other acceptable corporate purposes (e.g., capital expenditures), which may provide the Company with continued growth and a significantly higher internal rate of return. In addition to increasing the Company's financial strength, the Company's enhanced cash flow will enhance its creditworthiness. Not only will senior and mezzanine transaction lenders be encouraged to loan more into the transaction, private equity group(s) may be encouraged to provide transaction financing (even, e.g., where the transaction is being structured to take out an existing private equity investor).

Seller Financing Is More Attractive in ESOP Structure

Another significant financing advantage of the ESOP structure is that seller financing is generally more attractive in an ESOP purchase transaction than in a traditional M&A acquisition. First, the fact that the Company's enhanced cash flow will permit its senior indebtedness to be repaid at an accelerated pace means that subordinated seller financing can be repaid more rapidly. Second, if a Seller who provides a portion of the transaction's financing has made a Section 1042 election, the transaction can be structured so that the Seller receives a higher subordinated return and principal payments that are received on a tax-free basis (as opposed to traditional M&A installment payments for which only a portion of each installment constitutes a return to basis). Finally, because an ESOP company's management team generally remains in place to continue running the entity's day-to-day operations, Sellers may feel more comfortable providing financing than they would in a traditional third-party purchaser M&A transaction.

ESOP Structure Provides Greater Financial Flexibility

The fact that ESOP purchase transactions can often be closed with a much greater percentage of Seller financing (which can, of course, be taken out in the future when credit conditions have improved) makes ESOP purchase financing definitely more flexible than traditional M&A financing in a down economy. This flexibility is accentuated when the transaction can be structured to roll monies into the ESOP from other retirement plans and/or IRAs. The fact that an ESOP transaction structure creates an inherent source of funding that can be used to repay transaction indebtedness (as described below) is yet another advantage of its financial flexibility.

Inherent Sources of Funds That Can Be Used to Repay Transaction Debt

The Company can, of course, take from its cash flow the dollars it will need to make the contributions or pay the dividends/distributions that will enable the ESOP to repay its loan. Other sources inherent in the transaction structure can include the following:

The annual use of dollars previously contributed as a matching contribution to the Company's 401(k) plan (with the Company continuing the "match," if desired, within the ESOP in the form of Company shares);


The use of the tax dollars saved by the Company due to either ESOP-generated deductions in a C corporation context or the ESOP's ownership percentage in an S corporation context

Stable Company with Improved Performance

Although Company Is Leveraged, Its Management Team Will Likely Remain in Place, and Enhancements to Cash Flow Can Provide Continued Growth

Like any other leveraged transaction, a leveraged ESOP purchase transaction puts a large amount of debt on the Company's books. However, unlike traditional M&A transactions, the Company's management team will in all likelihood remain in place to run the Company's day-to-day operations. Moreover, because transaction indebtedness is essentially paid with pre-tax dollars, the Company's cash flow is increased in a way that can provide the Company with continued growth and a sufficiently higher internal rate of return. In the event that the Company operates on a post-transaction basis as an S corporation, the Company's increased cash flow related to the ESOP's ownership percentage can continue well beyond the life of the transaction's term debt.

ESOP Provides Employees with Beneficial Interest in the Company, Which May Increase Production and Increase Company's Chances of Survival

The fact that the ESOP will provide employees with a beneficial interest in the Company will also incentivize employees financially, providing the Company with positive effects in terms of attracting, retaining and motivating employees to increase the Company's productivity. Data referenced by the National Center for Employee Ownership (NCEO) also decisively shows that companies that share ownership broadly with employees are less likely to go out of business, generate more jobs and create an average of three times the retirement benefits as comparable non-employee ownership companies. Tony Matthews, director of employee ownership at the Beyster Institute, has also said that "in tough times like these, giving employees a stake in the outcome inspires people to put in the extra effort required to insure the survival of a company."


With both M&A advisors and private equity groups needing to find new ways to compete in tighter credit markets, using an ESOP as a stalking horse and/or an acquisition tool may provide a competitive edge. The parties to a leveraged ESOP transaction can readily control its timing, and 100 percent of a company's equity need not be purchased in a single transaction.

The ESOP purchase structure is also advantageous in that an ESOP can purchase shares with pre-tax dollars and access other qualified plan and IRA monies to both (i) reduce the amount of acquisition indebtedness and (ii) provide a partial funding source for periodic loan payments. The factors that make seller financing so attractive under an ESOP purchase structure also provide the structure with a competitive advantage in a down economy in which it is difficult to fund 100 percent of a purchase with external financing. The fact that an ESOP purchase can close without going to market and pay up to a full economic fair market value provides additional advantages that greatly minimize the risk that a purchase agreement may never be executed.

Finally, the fact that ESOP financing can enhance cash flow, which can be used for both debt reduction and periodic growth, makes the ESOP structure worth considering not only as a down economy alternative to a traditional M&A transaction, but also as a go-forward investment and/or acquisition platform.

There are, of course, considerations to the ESOP transaction structure that must be explored and quantified (e.g., the requirement that a privately held company must repurchase shares distributed to departing employees at fair market value). With proper planning these considerations need not, however, become structural drawbacks. In a down economy in which M&A advisors and private equity groups are looking for flexible structures that can take an acquisition to completion, the leveraged ESOP purchase structure presents a compelling alternative.

New York Cases Involving S Corporations
By Robert J. McDermott

The New York State Tax Appeals Tribunal and Division of Tax Appeals recently issued two opinions upholding planning techniques that had the effect of exempting from New York State personal income tax gains from the sale of New York businesses conducted by S corporations owned by nonresidents of New York (See Matter of Baum, Tax Appeals Tribunal, February 12, 2009; Matter of Mintz, Division of Tax Appeals, June 4, 2009).

Generally a nonresident shareholder of a New York S corporation is subject to personal income tax on the income of the corporation to the extent it is from New York sources. Gain on the sale of shares of the corporation, however, is not taxable since it represents income from intangible property which has a situs at the residence of the owner. When the business is to be sold, purchasers will generally prefer to purchase assets rather than stock for both tax and non-tax reasons—principally, stepping up the tax basis of the assets to the purchase price and avoiding unknown liabilities of the corporate entity. If a New York S corporation sells its New York business at a gain, the gain will flow through to nonresident shareholders in the same fashion as operating income and will be subject to New York tax. This gain will result in a step up in the shareholders' tax basis in the shares, but this will provide no New York tax benefit for the nonresident holder on disposition of the shares since the shares have a situs outside New York.

Under section 338(h)(10) of the Internal Revenue Code, the parties to the sale of the stock of an S corporation can elect to have the transaction treated as if it involved a sale of the corporation's assets followed by a complete liquidation of the corporation in which the sales proceeds were distributed to the shareholders. If this treatment applied for New York State tax purposes, gain on the deemed sale of New York assets would be taxable to the nonresident shareholders as described above. In the Baum case, the New York State Tax Appeals Tribunal held that the federal treatment does not apply for New York tax purposes and that the nonresident shareholder's sale of shares is exempt from tax. This appears to give the parties a double benefit—a step up in tax basis for the purchaser and a tax-free sale for the seller. It is conceivable that the Department of Taxation and Finance will challenge the purchaser's step up, but it would face an obstacle in the New York Tax Law's provision that the purchaser's tax calculation under both the personal income tax (NY Tax Law §§ 612(a), 631(a), 632(a)(2)) and the corporate franchise tax (NY Tax Law § 208.9) begins with federal taxable income which reflects the step up.

The second case, Matter of Mintz, involved an actual sale of substantially all the assets of a New York S corporation followed by its complete liquidation. If the sale had been for cash, the corporate gain on the New York assets would have subjected the nonresident shareholders to New York personal income tax. By the simple expedient of issuing a promissory note in the amount of the $22 million purchase price and paying the note in the month after the closing, a New York tax exceeding $650,000 was eliminated. In this case, the interplay of federal rules for corporate acquisitions and the New York Tax Law was again involved. Under the Internal Revenue Code, if a corporation receives an installment obligation on a sale of assets during a 12-month period beginning on the date of the adoption of a plan of liquidation and ending on the completion of the liquidation and distributes the obligation to its shareholders in the liquidation, the receipt of payments on the installment obligation will be treated as received by the shareholders in exchange for their stock (IRC § 453(h)). In the case of an S corporation, no gain or loss is recognized by the liquidating corporation with respect to the installment obligation and the character of the gain or loss to the shareholder will be determined "in accordance with the principles of section 1366(b)" (IRC § 453B(h)). Section 1366(b) states that "the character of any item included in a shareholder's pro rata share [of the corporation's income] shall be determined as if such item were realized directly from the source from which realized by the corporation, or incurred in the same manner as incurred by the corporation." Under the Internal Revenue Service's interpretation of these provisions, it appears that if the only consideration received by the corporation consists of installment obligations, the corporation's gain on the sale of its assets is not recognized and the only gain taken into account is the shareholder's gain on the stock, if any, measured by the difference between the payments on the installment obligation and his or her basis in the stock. The basis is not adjusted upward for the unrecognized gain of the corporation (See Treas. Reg. § 1.338(h)(10)-1, Example (10)). Presumably, the shareholder level gain is to be characterized on some sort of allocated basis by reference to the character of the unrecognized gain at the corporate level "under the principles of section 1366(b)" (See also NY Tax Law §§ 617(b), 632(a)(2), 660(a)).

The Mintz case concluded that since the shareholder's gain is measured by the difference between the amount realized on the disposition of the shareholder's stock and the shareholder's tax basis in the stock, the transaction should be viewed as a sale of an intangible asset by a nonresident of New York and therefore not subject to the personal income tax. There is accordingly no need to reach the question of the character of the gain. The administrative law judge's determination reads in part as follows:

. . .IRC § 1366(b) impacts and determines the character of income or gain received, but only to the extent the income or gain itself is includible in a taxpayer's income in the first instance (i.e., for federal purposes and for New York State resident taxpayer purposes). In short, IRC § 1366(b) would apply if the gain in question were included in petitioners' New York source income. However, since the gain petitioners received (via periodic installment payments) in exchange for their stock in [the corporation] was gain from the sale of stock held by a nonresident, the same is not includible as New York source income, is not subject to taxation by New York State, and IRC § 1366(b) simply does not apply or have any impact under these circumstances.

In effect, the determination seems to say that the test of taxability under the New York Tax Law should be applied after the application of sections 453(h) and 453B(h) of the Internal Revenue Code but before the application of section 1366(b).

It is not known whether the Department of Taxation and Finance will appeal the Mintz determination to the Tax Appeals Tribunal. It cannot appeal the Baum decision. In any event, the principal lesson of these cases is that small changes in structure can produce dramatically different results.

Pre-Packaged Sales in Administration in the United Kingdom
By Brigid Breslin

A pre-packaged business sale (or "pre-pack") is an arrangement under which the sale of a company's business or assets is agreed in principle with a buyer prior to the appointment of an insolvency practitioner (most commonly an administrator), who then executes the sale shortly after his or her appointment.

The number of pre-packs in the United Kingdom have increased considerably in the past 12 months and are expected to rise in line with general company insolvencies. Recent high-profile deals such as the management buy-outs of MFI, The Officers Club and Whittard of Chelsea have brought pre-packs to the media's attention. Concerns have been raised regarding their lack of transparency, susceptibility to abuse and undesirable resemblance to the outlawed "phoenix companies" phenomenon.

These concerns have led to the adoption of a new statement of practice for insolvency practitioners involved in pre-pack administrations and to the publication of a report by the Commons Business and Enterprise Committee on May 6, 2009.

The Legal Framework Within Which Pre-Packs Are Effected

Although the UK Insolvency Act 1986 does not expressly provide for pre-packs, the courts have supported their use, confirming that an administrator has the power to execute a pre-pack despite the objections of the majority creditor (DKLL v. HMRC [2007] EWHC 2067). Earlier cases have confirmed that administrators are permitted to sell the assets of a company in advance of their proposals being approved by unsecured creditors and without the direction of the court (Re T& D Industries [2000] 1 WLR 646; Re Transbus International [2004] EWHC 932). This line of cases arguably supports the philosophy of limiting judicial intervention in the economic and business decisions of experienced and licensed insolvency practitioners. This is in keeping with the purposes of the provisions introduced by the Enterprise Act 2002, which streamlined the administration process, focusing on company rescue and reducing the courts' involvement.

An administrator must perform his or her functions with the primary objective of (a) rescuing the company as a going concern or, failing that, (b) achieving a better result for the company's creditors as a whole than would be likely if the company were wound up or, failing that, (c) realizing property in order to make a distribution to one or more secured or preferential creditors. In a situation where the administrator considers it is not reasonably practicable to pursue the primary objective (for example, where there is insufficient cash to carry on the company's business as a going concern), the administrator might well conclude that a pre-pack sale is the optimal means of achieving objective (b) or failing that, objective (c).

Advantages and Disadvantages of Pre-Packs

The main criticism that has been levelled at pre-packs is the lack of transparency in the proceedings because unsecured creditors generally only become aware of the sale after it has been agreed, as opposed to the position in a traditional form of administration, where creditors have the opportunity to consider and vote on the administrator's proposals in a creditors' meeting. Secured creditors are not affected because they are involved in the pre-pack strategy in giving their consent to release their security over the company's assets prior to completing the sale. However, the implementation of a recent Statement of Insolvency Practice goes some way towards meeting this concern.

Another concern that has been raised is that proceeds may not necessarily be maximized in the case of a pre-pack, as they are usually effected with limited marketing compared to a normal administration. In many cases, the sale is to the original owners or management who led the company into insolvency. This has led to the perception of pre-packs as an indirect means of creating phoenix companies (a practice outlawed by the Insolvency Act 1986), resulting in a new company with a very similar name, and the same or similar management, business and employees but without the liabilities to the creditors of the insolvent company. Research by Dr. Sandra Frisby of the University of Nottingham concluded that, on average, unsecured creditors recover only 1 percent of their debts during a pre-pack (compared to 3 percent in a private business sale), whereas secured creditors recover an average of 42 percent of debts in a pre-pack (compared to 28 percent on a business sale). In the pre-pack sale of Cobra Beer agreed on May 29, 2009, it has been reported that unsecured creditors who are owed up to £75 million will receive nothing whereas secured creditors who are owed approximately £20 million will be paid in full. However, the percentage of debts recovered by unsecured creditors is inherently limited by their lowly position in the hierarchy of stakeholders.

There is a potential conflict of interest on the part of the proposed administrator (whose appointment may be dependent on his or her prospective approval to the pre-pack strategy). The Commons Committee has said that the appearance of self-serving alliances between directors and insolvency practitioners could lead to reputational damage to the insolvency system.

Complaints have been received by the Commons Committee that competitors are adversely affected by pre-pack sales, as they continue to carry costs and honor financial obligations that the pseudo "phoenix companies" have shed.

Furthermore, it has been suggested that there is a danger that pre-packs represent a mere short term fix, potentially requiring further restructuring measures if the business is to survive in the long term. Unsecured creditors complain that jobs have been saved at their expense.
On the other hand, it should be borne in mind that pre-packs can and often do result in a fast and seamless business transfer, reducing the damage that protracted insolvency proceedings would have on the goodwill of the business, saving more jobs, avoiding the flight of key employees and reducing the costs that a normal administration would involve. Pre-pack administrations tend to be used where commercial pressures require urgent action. It should also be acknowledged that in some cases, the only viable alternative to a pre-pack is the liquidation of the company (because the lack of available cash prevents the carrying on of the business through the administration process). Pre-packs are an important restructuring tool particularly in the service industry, where much of the value of the company is in the staff and the client base rather than in tangible assets.

Considerations for Directors

Directors involved in a pre-pack should take independent legal advice, particularly if they will acquire an interest in the company's business or assets through the pre-packed sale. Where a company is insolvent or on the verge of insolvency, the directors owe a duty to act in the best interests of the creditors of the company. In particular, in the context of a pre-packaged sale to management, directors will be concerned to avoid any risk of allegations of:

Transactions in fraud of creditors under section 207 of the Insolvency Act 1986

Acquisition of assets at an undervalue

Misfeasance or breach of fiduciary duty through misapplication or retention of company property, in respect of which they could incur personal liability under s.212 of the Act or which could lead to their disqualification as directors

Involvement in the management of a company with a prohibited name (phoenix companies) under section 217 of the Act

Improving Transparency in Pre-Pack

The Association of Business Recovery Professionals has published a Statement of Solvency Practice 16 ("SIP 16") which took effect on January 1, 2009, and has been adopted by various regulatory bodies including the Law Society. The new guidance aims to provide greater disclosure of information to creditors, to increase clarity about the administration process and to restore confidence in respect of pre-packs.

The new measures directly address some of the main concerns with pre-packs, in particular, the lack of transparency. Administrators should now include in their first notification to creditors, among other things, an explanation of the background to their appointment, the reasons why they consider that a pre-pack would provide the best results to the creditors as a whole, any valuations obtained of the business or the underlying assets, alternative courses of action that were considered by the administrator, the purchase price and payment terms, the identity of the purchaser, details of any connection between the purchaser and the directors and shareholders of the relevant company, and whether efforts were made to consult with major creditors.

In addition, creditors wishing to complain about a pre-pack or who consider that they have been disadvantaged by any corporate insolvency process, have been encouraged by the Insolvency Service (which authorizes and regulates the insolvency profession) to telephone the Insolvency Service hotline.

In the recent case of In the matter of Kayley Vending Limited [2009] EWHC 904, Cooke J. expressed the view that in pre-pack cases where the administrator is appointed by the court, it was likely that the matters identified in SIP 16 should be supplied to the court (insofar as known or ascertainable at the date of the application) for the purposes of assisting it in deciding whether to make an administration order. In respect of information which is commercially sensitive until completion of the transaction, an application could be made for a direction by the court that it be excluded from public inspection.

How the SIP May Affect the Liability of Administrators

The new SIP 16 guidelines are perceived as a significant improvement to the previous regime and have largely been welcomed by insolvency practitioners. It is considered that the additional disclosure to creditors may potentially lessen the likelihood of action by creditors against administrators in pre-pack situations for misfeasance (on the basis of misapplication of property of the company), breach of fiduciary or other duty in relation to the company or failure to perform their functions as quickly and efficiently as is reasonably practicable. Failure to comply with SIP 16 could result in the administrator being subject to disciplinary or regulatory action.

The Future

The Commons Committee has expressed the view that the interests of unsecured trade creditors must take a higher priority, especially where the pre-pack is a sale to the existing management. If the introduction and monitoring of SIP 16 does not prove effective, the Commons Committee has suggested giving stronger powers to creditors or to the court.


The increasing use of pre-packs has brought into focus the inherent tension between the desirability for transparency and the need to act with speed so as to preserve goodwill with a view to maximizing value for creditors and other stakeholders (including clients and employees). The combined effect of SIP 16 and the decision in DKLL v. HMRC have created a better framework for pre-packs going forward, the former increasing transparency, with the latter giving due latitude to experienced insolvency practitioners to carry out pre-packs in tight timeframes while preserving the goodwill of the business and promoting the interests of stakeholders.

Rosa Sanchez was also a principal author of this article.

New Belgian Law on Business Reorganization Takes Effect
By Patrice Corbiau

Belgium has modified its law on business reorganizations that involve distressed companies. The new law of January 31, 2009, on the continuity of companies came into force on April 1, 2009, replacing an unpopular and rigid law on judicial composition proceedings that dated to 1997.

This new law simplifies the rules and procedures for reorganizing distressed companies by providing a variety of new flexible out-of-court and in-court options designed to facilitate business recovery.

From an M & A perspective, the new law also allows a liability-free transfer of assets of the distressed company without the latter having to file for bankruptcy.

Further, the new law removes a number of tax obstacles that often proved prohibitive for restructuring operations.

Out-of-Court Option

Under the new law, the Chairman of the Commercial Court, at the request of a distressed company, may appoint a neutral mediator to help the company restructure its liabilities and negotiate with its creditors. Because these negotiations are conducted by the mediator on a confidential basis, the company can avoid negative publicity that might further damage its creditworthiness.

The new law also allows a distressed company to negotiate an amicable settlement with at least two or more of its creditors without entering into a court-supervised reorganization.

The main benefit to creditors of such an agreement is that settlement payments remain enforceable vis-à-vis all creditors even if the distressed company later files for bankruptcy. To secure this benefit, however, the settlement agreement must be filed with the Commercial Court, and the parties must expressly indicate that the settlement's objective is to improve the financial position of the debtor or to reorganize its business. This is a significant change from the previous 1997 law.

Court-Supervised Reorganization

The new law provides the following new court-supervised reorganization options to help distressed companies as soon as their continuity is jeopardized:

A court-assisted voluntary settlement agreement with two or more creditors. This agreement has the same effect as the out-of-court settlement described earlier, but is supervised by (rather than just filed with) the Commercial Court.

A collective agreement with creditors on a reorganization plan. Under this option, the distressed company needs to prove that the continuity of its business is threatened and to prepare a reorganization plan. This plan must be approved by a majority of the creditors representing at least half of the outstanding claims, under the supervision of the court.

A transfer of all or part of the company under court supervision.

These options are open to companies as soon as their continuity is in jeopardy.

When filing a request for court-supervised reorganization, the distressed company must specify which option it is requesting. However, the new law makes it possible to switch from one option to another as the company's situation evolves, which was impossible under the previous rigid system.

A key new feature of the new court-supervised reorganization procedure is that the debtors remain in control of their business during its restructuring. Under the previous 1997 law, management of the distressed business was assigned to court-appointed administrators.

As soon as the court-supervised reorganization is initiated, the distressed company is given a six-month reprieve during which it cannot be declared bankrupt and no enforcement measures can be taken against it. The court may extend this period twice with each extension lasting an additional six months, bringing the maximum period of reprieve to 18 months.

Once the distressed business reaches a collective agreement with its creditors, the court will set a binding repayment schedule. So long as the distressed company satisfies the terms of this schedule, creditors may not take enforcement action. Repayment schedules may not exceed five years from the date that the collective agreement is approved by the court.

The court can, however, revoke the plan for certain serious reasons—for example, if the company has provided false information to the court or to the creditors, or if the company is not in compliance with the conditions of the plan.

Transfer of Business

The new law explicitly allows for a transfer of (part of) the business or the assets/activities of the distressed company and provides two procedures to do so.

Under the first procedure, the transfer of the business is ordered by the Commercial Court, after the debtor agrees and after the employees are consulted.

Under the second procedure, the transfer can be ordered by the Commercial Court without the agreement of the debtor. This forced transfer can be requested by the public prosecutor, a creditor or any party who can show a legitimate interest in acquiring the business. This forced transfer can be ordered only if one of the following conditions is satisfied:

The distressed company is in a state of virtual bankruptcy without having filed for court-supervised reorganization.

The Commercial Court rejects the requested court-supervised reorganization.

The creditors refuse the plan for court-supervised reorganization proposed by the distressed company.

The Commercial Court refuses to ratify the reorganization plan.

When the Commercial Court orders such a forced transfer, it also appoints a judicial agent who is in charge of completing the transfer.

The Tax Perspective

The new law amends a number of tax provisions. Notably, it exempts from taxation the profits made by the debtor within the framework of a court-supervised reorganization. Such profits can, for example, include the price received for a transfer of business/assets, and/or the advantage received if a creditor waives a debt.

This may allow for a merger or acquisition transaction driven by tax planning considerations. For instance, a creditor who waives a debt as part of a transaction under the new law may be able to deduct the amount waived from its own taxes (under certain conditions), while the debtor is not taxed on the proceeds.


It has long been clear that the 1997 reorganization law and its subsequent modifications did not provide a practical framework for the reorganization of distressed companies. The new law introduces a less rigid system that is similar to Chapter 11 in the United States, which offers various practical tools to distressed businesses to facilitate financial recovery.

Since their implementation on April 1, 2009, the reorganization measures provided by the new law have been very successful. A number of companies facing financial difficulties have already applied for court-supervised reorganization under the new rules. This clearly shows that the new rules meet the needs created by the current difficult economic conditions.

From an M&A perspective, the new law will also certainly create new opportunities for potential acquirers of distressed company assets. This is particularly true given that acquirers can obtain a transfer of assets liability-free without having to wait for the actual bankruptcy of the distressed company.

Jacques Pieters was also a principal author of this article.

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